Section 1031 of the Internal Revenue Code lets you sell an investment property and defer capital gains tax by rolling the proceeds into a replacement property. It is one of the most powerful wealth-building tools available to real estate investors, and one of the most misunderstood.
The tax deferral is not a forgiveness - it is a postponement. But for investors who keep rolling from property to property, it is a postponement that can last a lifetime, with the tax basis eventually stepping up to fair market value at death under current law.
The basic rules
Four conditions must be satisfied for a valid 1031 exchange:
Like-kind property. For real estate, this is broadly interpreted. A single-family rental can exchange into a multifamily building, a commercial property, raw land, or another single-family rental. The requirement is that both properties are held for investment or business use - not personal use. Your primary residence does not qualify.
45-day identification window. You have 45 days from the sale of your relinquished property to identify potential replacement properties in writing to a qualified intermediary. This clock starts the day you close on the sale and does not pause for weekends or holidays.
180-day closing window. You have 180 days from the sale of the relinquished property to close on the replacement. This runs concurrently with the 45-day window, not consecutively.
Equal or greater value. To defer 100% of the gain, you must purchase a replacement property of equal or greater value and reinvest all the equity. If you buy down in value or take cash out (called "boot"), the boot is taxable in the year of the exchange.
The IRS guidance on like-kind exchanges covers the technical requirements in detail.
The qualified intermediary requirement
You cannot touch the money between transactions. A qualified intermediary (QI) - also called an exchange accommodator - holds the proceeds from your sale and releases them directly to the closing of your replacement property.
If the funds hit your bank account at any point, even briefly, the exchange is disqualified and the full gain becomes taxable immediately. This is a hard rule with no exceptions.
QI fees range from $750 to $1,500 for a standard exchange. Choose a QI with bonded escrow accounts and errors-and-omissions insurance. There have been cases of QIs misappropriating exchange funds. The fee for a reputable operator is worth it.
The three identification rules
Within your 45-day window, you must identify replacement properties using one of three rules:
Three-property rule. You can identify up to three properties regardless of their combined value. Most investors use this rule.
200% rule. You can identify any number of properties as long as their combined fair market value does not exceed 200% of the value of the relinquished property.
95% rule. You can identify any number of properties if you actually close on 95% or more of the total identified value. This rule is rarely practical.
Most investors identify two or three properties under the three-property rule and have a clear primary target with backups in case the first falls through.
What happens to your tax basis
When you complete a 1031 exchange, your tax basis in the replacement property is adjusted down by the amount of gain you deferred. This means future depreciation deductions are calculated on a lower basis, and when you eventually sell without exchanging, the deferred gain plus any additional gain is taxable.
Investopedia's 1031 exchange guide walks through the basis calculation mechanics, which can get complex in exchanges involving boot or partial rollovers.
Common mistakes
Missing the 45-day window. No extensions are granted except in presidentially declared disasters. Investors who do not have a replacement property in mind before selling often find themselves scrambling and settling for inferior properties.
Underestimating boot. Paying off a larger mortgage on the relinquished property than you take on with the replacement creates mortgage boot, which is taxable. Your replacement loan must be equal to or greater than your relinquished loan.
Using exchange funds for repairs. You cannot use 1031 proceeds to fix up the replacement property directly. An improvement exchange (also called a 1031 build-to-suit) requires a different structure and is more complex to execute.
Not accounting for depreciation recapture. Even in a 1031 exchange, depreciation recapture (taxed at 25% under current law) follows the basis into the new property. It does not disappear - it is deferred.
This article is for informational purposes only and does not constitute financial, legal, or tax advice. Consult a qualified professional before making investment decisions.
